Factor investing - a wide highway ahead?

As investors continue to add factor-based strategies to their portfolios, industry watchers have wondered: are factor strategiesgetting too popular?

I hate waiting in traffic. I don’t like the stops and starts, the feeling of crawling along, and just all that crowding. As any driver knows, it’s not just the total number of cars that matter, but also the size of the road itself: the same amount of traffic on a freeway versus a winding single-lane road makes all the difference between a smooth journey and a traffic jam.

More than $18 billion flowed into U.S.-listed smart beta ETFs in the first half of 2017, following the $43 billion invested in 2016.1 These numbers sound impressive, so not surprisingly, some investors have wondered if factor strategies have become crowded, eroding their potential gains. But in the broader context: are factor strategies a highway or a backcountry road? Have factor strategies reached their capacity?

Let’s start by citing some important facts and figures.

How much is invested in factorstrategies today?

Currently, assets in factor strategies are simply dwarfed by the assets invested in traditional vehicles, such as passive and active funds.

As one example, consider smart beta funds that invest in S&P 500 Index constituents. The S&P 500 Index represented $19.2 trillion in market value as of December 31, 2016. Of the $8.7 trillion in assets indexed or benchmarked to the S&P 500, actively managed mutual funds accounted for $5.7 trillion. In comparison, U.S.-listed, U.S. equity smart beta ETFs represented approximately $224 billion, or less than 1.2% of the market capitalization of the S&P 500 Index. The current amount invested in smart beta funds is tiny!

Unlike some strategies prone to capacity constraints such as micro-cap stocks or active strategies that traffic in thinly traded names, factor strategies have generally tended to invest in more liquid securities trading in deep markets. Factor funds may be more able to invest new fund flows without unduly affecting the prices of securities, giving them the potential to accommodate large flows.

Trillions of dollars in active fundsalready follow factors

While the amount directly invested in smart beta strategies is miniscule, many institutions are already factor investors, even though they might not explicitly allocate to smart beta or factor strategies. Our research decomposed active mutual fund returns into three components: factors, time-varying components and security selection. Of the trillions of dollars in U.S. active mutual funds, we believe that the first component, static factor exposures, may represent well over $2 trillion of assets under management.

In other words, money is already following these factor strategies; what is changing is the way investors are accessing those factors.

Measuring the capacity offactor strategies

There are several ways to estimate the capacity of factor-based strategies, including asset ownership, capital flows and transaction costs. Let’s consider transaction cost estimates, which may not provide definitive measures of capacity, but are certainly informative measures of real-world trading experienced by investors.

Each incremental investment into a factor-based strategy incurs an additional transaction cost. There is a breakeven point where all investors’ new flows are eaten up by transaction costs, offsetting the historical smart beta premiums. How far away are we from that breakeven point for assets under management, which indicates that there is no additional capacity?

To address the capacity question, we used Blackrock’s proprietary transaction cost model, which covers tens of thousands of securities, including more than 50,000 equities. The model is used by BlackRock investment teams on a daily basis and incorporates turnover, volume, market-wide and stock-specific risk, commissions, taxes and spreads and other inputs. The model is used for trading across all of our portfolios — not just the securities within smart beta strategies.

What do transaction costs tell us about the potential capacity of factor strategies?

With a five-day trading horizon, which is appropriate for large trades, value, momentum, quality, size and minimum volatility factors each show capacity potential in the hundreds of billions. Some factors, like minimum volatility, may have capacity well over $1 trillion. The momentum factor has the highest turnover and volatility relative to the other style factors, and accordingly, should have the smallest capacity. Yet, even for momentum, our estimate of capacity exceeds $320 billion.

For the majority of the factors, the breakeven point for transaction costs indicates a capacity that far outstrips the assets currently invested in those style factors.

What about crowding and valuation?

Crowding, or a crowded trade, presents a risk of investors who hold large and similar positions exiting those positions simultaneously. Crowding may manifest in short-term trends and high, short-term valuations. These are important concerns, but they are different from long-term capacity considerations.

All assets undergo periods of upward or downward trends and high or low valuations. A skillful investor might be able to use relative strength and valuation metrics to tilt factor positions gradually over time. Other signals useful in a factor-tilting framework might include dispersion and the economic regime. Read my recent post on factor tilting for more on how tilts may help improve returns and check the outlook for our latest views on factor over- and underweights.

Ample room on the road

So, what about the naysayers claiming that factor strategies are at capacity? We’ve done the research and it suggests there is large capacity potential in smart beta and factor strategies. We believecapacity could be at least hundreds of billions and, in many cases, trillions of dollars of assets — more than 100 or 1000 times more than what is invested in factor strategies today — for capacity to be reached. Factor strategies appear to have a wide highway ahead.

Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses which may be obtained visiting the iShares ETF prospectus pages. Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal.

Investing involves risk, including possible loss of principal.

In Latin America and Iberia, for institutional investors and financial intermediaries only (not for public distribution). This material is for educational purposes only and does not constitute investment advice or an offer or solicitation to sell or a solicitation of an offer to buy any shares of any fund or security and it is your responsibility to inform yourself of, and to observe, all applicable laws and regulations of your relevant jurisdiction. If any funds are mentioned or inferred in this material, such funds have not been registered with the securities regulators of Brazil, Chile, Colombia, Mexico, Panama, Peru, Portugal, Spain Uruguay or any other securities regulator in any Latin American or Iberian country and thus, may not be publicly offered in any such countries. The securities regulators of any country within Latin America or Iberia have not confirmed the accuracy of any information contained herein. No information discussed herein can be provided to the general public in Latin America or Iberia. The contents of this material are strictly confidential and must not be passed to any third party.

There can be no assurance that performance will be enhanced for funds that seek to provide exposure to certain quantitative investment characteristics ("factors"). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective.

The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.

This document contains general information only and does not take into account an individual's financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).